Class Lecture (Final)
Islamic Financial System (Fin-5402)
Capital Market
Definition of Stock/
Equity Market:
— A stock market or equity
market is a public entity for the trading of company stock (shares)
and derivatives at an agreed price.
— These are securities listed
on a stock exchange as well as those only traded privately.
— The stocks are listed and traded on
stock exchanges which are entities of a corporation or mutual
organization. The largest stock market in the USA, by market
capitalization, is the NYSE.
Definition of Stock Exchange:
—
Stock
exchange can be defined as “an association, organization, or an individual who
is established for the purpose of assisting, regulating, and controlling
business in buying, selling and dealing in securities.”
— A market in which securities are
bought and sold: "the company was floated on the Stock
Exchange".
— The initial offering of stocks and
bonds to investors is by definition done in the primary
market and subsequent trading is done in the secondary market.
— A stock exchange is often the most important
component of a stock market.
— Supply and demand in stock markets are driven
by various factors that, as in all free markets, affect the price of
stocks.
The Primary market
is the market where investors purchase newly issued securities.
Initial public offering (IPO): An initial public offer occurs when a company offers stock for sale to
the public for the first time.
An IPO involves several steps.
1.
Company
appoints investment banking firm to arrange financing.
2.
Investment
banker designs the stock issue and arranges for fixed commitment or best
effort underwriting.
3.
Company
prepares a prospectus (usually with outside help) and submits it to the Securities
and Exchange Commission (SEC) for approval. Investment banker circulates
preliminary prospectus (red herring).
4.
Upon
obtaining SEC approval, company finalizes prospectus.
5.
Underwriters
place announcements (tombstones) in newspapers and begin selling shares.
Underwriting:
This is a way of distributing a newly issued security, such as stocks or
bonds, to investors. A syndicate of
banks (the lead managers) underwrites the transaction, which means they have
taken on the risk of distributing the securities. Should they not be able to
find enough investors, they will have to hold some securities themselves.
Underwriters make their income from the price difference (the "underwriting spread") between the price they
pay the issuer and what they collect from investors or from broker-dealers who
buy portions of the offering.
The Secondary market is the market where investor trade previously issued securities. An
investor can trade:
— Directly with other investors.
— Indirectly through a broker who
arranges transactions for others.
— Directly with a dealer who buys and
sells securities from inventory.
A
secondary market
can be organized as an exchange where buyers and sellers meet in one central
location to conduct trades. An example of an exchange is the New York Stock
Exchange. A secondary market can also be organized as an over-the-counter
market. In this type of market, dealers in different locations buy and sell
securities to anyone who comes to them and is willing to accept their prices.
An example of an over-the-counter market is the federal funds market.
Stock Exchange in Muslim Countries:
Many
Muslim countries, or those with a majority Muslim population, have well
established stock markets, for example, Bangladesh, Egypt, Indonesia, Malaysia
and Pakistan. These stock exchanges are basically Western style markets
tolerating practices that may not strictly adhere to Islamic principles.
Importance/Roles/Functions
of Stock Market:
The stock exchange helps achieve
various benefits. It:
1.
provides
a market place where a large number of sellers and buyers can meet,
2.
helps
remove the apprehension of investors, the buyers, regarding future liquidity
problems, that may encourage the investors to accept a lower rate of return
than they would have done in the absence of the exchange and consequently lead
to reducing the cost of equity capital, hence reducing the average cost of
capital of the firm,
3.
helps
provide more representative prices of securities than the case would be with
separately organized markets,
4.
provides
a means of testing the validity of securities by assigning a value to these
securities, that is influenced by the views of specialized experts in the
market, and
5.
Provides
an effective way of absorbing new issues of securities which helps corporations
to raise funds.
Islamic Stock Exchange:
Malaysia
is making solid progress in establishing the necessary infrastructure to
facilitate stock trading in accordance with Islam. Islamic broking houses and
Islamic managed funds operate and a separate “Islamic Index” has been
established comprising 179 permissible stocks on the Kuala Lumpur Stock
Exchange.
Listing on an Islamic stock exchange:
The
listing requirements for an Islamic stock market will require scrutiny, not
only of the financial performance and soundness of firms, but also of the
religious acceptability of their business activities.
Non-Muslim in Islamic Stock exchange:
Example,
where the major stockholders are not Muslims, but conduct their affair in a way
that does not contravene any principles of Islam. Should these firms be allowed
to list on an Islamic stock exchange?
Bank
Islam Malaysia, for example, conducts a substantial amount of its financing
activities with firms that are owned by non-Muslims. In Bangladesh, Islamic
bank also provide services for non-muslim clients.
Definition of
stock:
A stock represents a
share of ownership of a corporation, or a claim on a firmʹs earnings/assets.
Stocks are part of wealth, and changes in their value affect peopleʹs
willingness to spend. Changes in stock prices affect a firmʹs ability to raise
funds, and thus their investment.
Definition of
'Common Stock'
A security that
represents ownership in a corporation. Holders of common stock exercise control
by electing a board of directors and voting on corporate policy. Common
stockholders are on the bottom of the priority ladder for ownership structure.
In the event of liquidation, common shareholders have rights to a company's
assets only after bondholders, preferred shareholders and other debtholders
have been paid in full.
In the U.K., these are called "ordinary shares."
If the company goes bankrupt, the common stockholders will
not receive their money until the creditors and preferred shareholders have
received their respective share of the leftover assets. This makes common stock
riskier than debt or preferred shares. The upside to common shares is that they
usually outperform bonds and preferred shares in the long run.
Definition of
'Preferred Stock':
A class of ownership
in a corporation that has a higher claim on the assets and earnings than common
stock. Preferred stock generally has a dividend that must be paid out before
dividends to common stockholders and the shares usually do not have voting
rights.
The precise details as to the structure of preferred stock is specific to each
corporation. However, the best way to think of preferred stock is as a
financial instrument that has characteristics of both debt (fixed dividends)
and equity (potential appreciation). Also known as "preferred
shares".
'Common Stock' and Preferred stock in Islam:
Ownership shares issued by corporations and traded by investors include
both common stock and preferred stock. While there are several ways in which
the two types of stock differ, the most significant way, from an Islamic legal
point of view, is that preferred stocks guarantee the amount of the dividend.
Such a predetermined and guaranteed rate of return is prohibited for the
reason that it may be classified as riba. Thus, while an investor may share the
risks of ownership with other investors, the preferred status of the preferred
stock means that there is extra compensation for the owner for which the owner
has not had to pay. This, in simplified terms, amounts to riba al fadl. In
Lesson Two of this course, we will take a detailed look at riba and the forms
it may take. For similar riba-based reasons, fixed-income securities,
convertible notes, and the like are also prohibited.
As a general rule, then, Muslim investors may trade only in common
stock.
In some cases, however, preferred stock may be offered without a fixed
dividend or without a dividend at all. Even so, it is the right of the
shareholders to change those terms through a vote at their shareholders?
meetings. Thus, while a Muslim investor may purchase such stock, s/he may hold
it only for as long as it carries no fixed dividend. If the status of the stock
changes as a result of a vote, the Muslim investor will have to liquidate
his/her interest in the company immediately. And if a fixed-amount dividend is
received before the stock can be sold, the entire amount of the dividend will
have to be given away as charity.
Some concept and their application Islam:
'Insider
Trading':
The buying or selling
of a security by someone who has access to material, non-public information
about the security. Insider
trading can be illegal or legal depending on when the insider makes the trade:
it is illegal when the material information is still nonpublic--trading while
having special knowledge is unfair to other investors who don't have access to
such knowledge. Illegal insider trading therefore includes tipping others when
you have any sort of nonpublic information. Directors are not the only ones who
have the potential to be convicted of insider trading. People such as brokers
and even family members can be guilty.
Insider trading is legal once the material information has been made public, at
which time the insider has no direct advantage over other investors. The SEC,
however, still requires all insiders to report all their transactions. So, as
insiders have an insight into the workings of their company, it may be wise for
an investor to look at these reports to see how insiders are legally trading
their stock.
Buying on margin
or Margin trading:
Margin
buying refers to the buying of securities with cash borrowed from a broker, using other securities as
collateral. This has the effect of magnifying any profit or loss made on the
securities. The securities serve as collateral for the loan. The net value—the difference
between the value of the securities and the loan—is initially equal to the
amount of one's own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the
broker against a fall in the value of the securities to the point that the
investor can no longer cover the loan.
Example:
Jane buys a share in a company for $100 using $20
of her own money and $80 borrowed from her broker. The net value (the share
price minus the amount borrowed) is $20. The broker wants a minimum margin
requirement of $10.
Suppose the share price drops to $85. The net value
is now only $5 (the previous net value of $20 minus the share's $15 drop in
price), so, to maintain the broker's minimum margin, Jane needs to increase this
net value to $10 or more, either by selling the share or repaying part of the
loan.
Islamic perspective margin trading:
From an
Islamic perspective margin trading is clearly unacceptable. This has been
reinforced by the Council of the Islamic Fiqh Academy (CIFA) which considered
margin trading at its 1993 meeting. The CIFA ruled that it is not permissible
to borrow money with interest from a stockbroker, or other party, to buy shares
and to deposit them as security for the loan. However, this does not outlaw the
practice entirely, as it is possible to construct non-interest bearing
financial contracts to achieve the same thing. For example, in Malaysia, Bank
Islam Malaysia Berhad offers share financing through Mudarabah profit sharing
contracts.
Short Selling'
The sale of a security that is not owned by the seller, or
that the seller has borrowed. Short selling is motivated by the belief that a
security's price will decline, enabling it to be bought back at a lower
price to make a profit. Short selling may be prompted by speculation, or by the
desire to hedge the downside risk of a long position in the same security or a
related one. Since the risk of loss on a short sale is theoretically infinite,
short selling should only be used by experienced traders who are familiar with
its risks.
Consider the following short-selling example. A trader believes that stock SS
which is trading at $50 will decline in price, and therefore borrows 100 shares
and sells them. The trader is now “short” 100 shares of SS since he has sold
something that he did not own in the first place. The short sale was only made
possible by borrowing the shares, which the owner may demand back at some
point.
A week later, SS reports dismal financial results for the quarter, and the
stock falls to $45. The trader decides to close the short position, and buys
100 shares of SS at $45 on the open market to replace the borrowed shares. The
trader’s profit on the short sale – excluding commissions and interest on the
margin account – is therefore $500.
Suppose the trader did not close out the short position at $45 but decided to
leave it open to capitalize on a further price decline. Now, assume that a
rival company swoops in to acquire SS because of its lower valuation, and
announces a takeover offer for SS at $65 per share. If the trader decides to
close the short position at $65, the loss on the short sale would amount to $15
per share or $1,500, since the shares were bought back at a significantly
higher price.
Islamic perspective
of Short Selling'
Umer
Chapra strongly advocates the abolition of short selling in an Islamic market,
arguing that such sales are speculative and fail to perform any useful economic
function. The public interest, masalahah, is better served by
prohibiting short sales. The element of speculation involved in short sales
further suggests that short selling is unacceptable.
Speculations and
arbitrage:
SPECULATION : It is the transaction of members to buy or sell
securities on stock exchange with a view to make profits to anticipated raise
or fall in price of securities.
A
speculator will buy stock in anticipation of prices rising usually with a short-term
horizon. The danger of this, as observed by Brailsford and Heaney (1998), is
that what is initially planned as a short-term position, with a sale to be
completed before taking delivery of the stock, may well result in a longer term
position when the stock does not perform as expected. Such purchases are often
financed on margins or other forms of borrowing.
A speculator
will sell in anticipation of prices falling. This strategy may involve a short
sale whereby the speculator borrows stock from a broker with a view to
subsequently buying it at a lower price, thereby completing the deal.
Arbitrage: The simultaneous
purchase and sale of an asset in order to profit from a difference in the
price. It is a trade that profits by exploiting price differences of identical
or similar financial instruments, on different markets or in different forms. Related
to speculation is the practice of arbitrage. An arbitrageur is a particular type
of speculator who seeks to obtain a risk free return with a zero investment. An
example of a potential arbitrage opportunity is the existence of identical
assets at different prices in different markets. Such practices are more
difficult with modern communications and computerised trading, as price
discrepancies in different domestic markets are quickly eliminated from the system.
Arbitrage will be regarded as one aspect of speculation.
Islamic Perspective of
Speculations and arbitrage:
Islamic
economists and scholars that speculation, as described above, is unacceptable
because of its association with gambling and excessive risk taking. In
addition, speculation creates volatility. This undermines the orderly
functioning of the stock market while the profits of speculators are achieved
at the expense of other investors. Any potential benefit of speculation, for
example by injecting liquidity into the market is not considered by Islamic
scholars to outweigh the negative aspects. If any activity is deemed to be
forbidden and Haram, that activity cannot be acceptable under any circumstance.
BROKER: He is one act as an intermediary on behalf of others. A broker in a
stock exchange is a commission agent who transacts business in securities on
behalf of non-members.
— A broker deals with the jobber on
behalf of his clients. in other words, a broker is a middleman between a jobber
and clients
— A broker is merely an agent, buying
or selling securities on behalf of his clients
— A broker gets only commission for his
dealings
— The
broker deals in all types of securities
Definition of
'Hedge':
Making an investment to
reduce the risk of adverse price movements in an asset. Normally, a hedge
consists of taking an offsetting position in a related security, such as a
futures contract. An example of a
hedge would be if you owned a stock, then sold a futures contract stating that
you will sell your stock at a set price, therefore avoiding market fluctuations. Hedging naturally belongs to Islamic economic
objectives as long as it does not involve pure speculation and gambling-like
activities
Regulatory
body:
SEC-securities and exchanges
commission
CRB-Company Regulatory body
SAC-sharia Advisory council
Islamic
capital market screening system:
(Collected
from :islamic capital market product: development and challenges, published
byIRTI,IDB)
